President Trump’s real bet is on tax cuts

True to his campaign pledge to make “America first,” President Donald Trump has repeatedly asserted that he will do all it takes to boost wages and corporate profits. The slogan is understood as a promise to enforce aggressive trade policies and has become one of the main targets of Mr. Trump’s opponents. One ought to remember, however, that import tariffs are only one of the two pillars of the new president’s economic policy. The other consists of significant corporate tax cuts, whose aim is to encourage local entrepreneurs and lure foreign manufacturers into the United States.

To understand “Trumpenomics,” these two sets of measures must be examined jointly. If the Trump administration manages to implement the fiscal-policy side of the president’s program (lower corporate taxation), much of the protectionist talk will remain mere chest-thumping. Such bluster certainly fits Donald Trump’s populist disposition and may be wielded like a club as he tries to reposition America’s foreign policy. It is by no means obvious, however, that the new administration will transform most of its threats into actual policy measures.

Corporate tax

Introducing lighter corporate taxation is surely the right thing to do. It would boost production and serve Americans’ interests. (Strictly speaking, a company is a bundle of contracts. It is not an individual or an income earner; nor it is a consumer. A company is a group of cooperating individuals remunerated according to their contracts: some draw wages, others dividends or interest. There is no reason why governments should tax contracts: by themselves, they guarantee neither income nor wealth. Common sense would suggest taxing individuals’ ability to pay – in the form of income or consumption taxes).

Lower corporate taxation in the U.S. would also bring global benefits, especially if the cuts in America triggered a worldwide race to the bottom. By contrast, shielding U.S. companies from foreign competitors would have negative consequences, since it would discourage domestic innovation. That leads to lower investment and slower productivity growth. Of course, U.S. protectionism could also touch off a global trade war, which most certainly would lead to a devastating crisis.

It is too early to comment on the outcome of possible policies that the Trump administration may put into effect in the next months. However, the most likely domestic scenario will involve drastic cuts in corporate taxation. Protectionism will remain a useful threat, but will not drive a radically new approach to international trade relations. The reasons for this are presented below, along with a set of scenarios that may open internationally.

Words and deeds

Nobody is interested in setting off a trade war. This also applies to the U.S., where import barriers are unlikely to enhance growth and boost wages. The short-term beneficiaries of protectionism would rather be the shareholders of large American companies that face competition from imports. Soaring profits and stagnant wages, possibly coupled with higher inflation and bankruptcies in the export-oriented industries, are not an ideal recipe for boosting a U.S. president’s popularity. Mr. Trump probably knows it, and the members of Congress know it for certain.

Cutting corporate taxation and keeping trade flows running is a better course of action – in terms of economic performance and political approval. This does not mean that the new administration will abstain from saber-rattling or, possibly, making a few grand announcements calculated for maximum media impact. Nevertheless, they will stop short of a trade showdown.

Mr. Trump’s strategy on the world scene already has started to emerge as less antagonistic than anticipated, especially when it concerns the “big guys.” The president is more than willing to develop a friendly relationship with Russia, seems eager not to alarm China, and has already promised unwavering military support to Japan and South Korea, should North Korea misbehave. His hostility toward the European Union is directed at Brussels bureaucrats and the notion of centralized policymaking, not at EU member states. Mr. Trump is keeping the door open to developing bilateral relationships with a number of key countries, a course that he will probably pursue more vigorously after the elections in France and Germany.

More important is the likelihood that President Trump is using commercial threats to punish what he considers as unfair policymaking in other parts of the world. This applies to the current, overly loose monetary policies in the eurozone, China and Japan. A weakening of the euro, the yuan and the yen implies a strengthening of the dollar – an outcome that Mr. Trump considers adverse to America’s interests.

Notably, the president is focusing on the dollar exchange rate, which is visible to the ordinary voter and whose effects are easier to grasp. One might even suggest that the president cares more in this area about the effect (the exchange rate), than the cause (monetary policy). Be that as it may, his administration seems determined to react to bad policymaking in the rest of the world, even at the cost of creating tensions with its own central banking system, the U.S. Federal Reserve.

Double standard

If the Fed keeps its word and engages in a less generous monetary policy, Mr. Trump’s crusade for a weaker dollar becomes less credible. How can he object to what is being done by the Bank of Japan or the European Central Bank, if the Fed is also pursuing a monetary policy tailored to the peculiarities of the U.S. economy? The rest of the world could then argue that the problem is the strength of the dollar, not the weakness of other key currencies.

President Trump’s economic strategy applies a double standard and requires the rest of the world to toe the line. He promises to engage in tax competition, regardless of what the rest of the world thinks about corporate taxation. At the same time, he is demanding orderly cooperation in monetary policy, using protectionism as a bargaining chip.

Scenarios

While most observers have focused their attention on what is happening in Washington, it is likely that future scenarios will depend more on how other world leaders respond to the new administration’s actions. In particular, if the ECB changes tack and lets interest rates rise, exchange rates will adjust. If the euro stabilizes against the dollar, President Trump will have an excuse to backtrack on his announcements about trade flows with the EU.

Russia and China are a different matter. The threat of protectionism will recede if Russian President Vladimir Putin and Chinese President Xi Jinping succeed in developing a close personal relationship with the new president, which would allow trade matters to be included in broader geopolitical arrangements. In the opposite case, however, protectionism might explode.

The picture could also change radically if Frankfurt insists on quantitative easing and the Fed keeps its word and raises interest rates. At that point, a significant strengthening of the dollar would make it difficult for the Trump administration to suppress its protectionist urges. The president could either pick a fight with Congress (which is mostly pro-trade) or start a trade war with the Europeans.

Whether a local conflict of this sort escalates into a global problem will depend on non-economic issues, including the geopolitical balance between the global power trio – the U.S., Russia and China. In the worst-case scenario, multilateral trade negotiations will be put aside. Then the rest of the world would just have to suffer the consequences, or possibly respond by developing regional trade agreements of their own.